By Russ Faye
If you are a high-income sole proprietor or the owner of a small business searching for a tax-advantaged retirement strategy, defined benefit pension plans could be the ideal tool for your needs.
Here’s how to determine whether you should discuss this option with your trusted financial adviser.
How it works
A defined benefit pension plan is a qualified retirement plan to which you make an annual contribution, which fund a chosen level of retirement income you will receive at a predetermined future retirement date. You decide how much you want to save in pretax dollars during your earning years and how much you want to be able to withdraw upon retirement.
The calculation for the annual dollar amount that can be contributed requires a mathematical calculation performed by an actuary and factors in the client’s age, income, planned retirement age and investment performance.
The best candidates for these plans are business owners with few full-time employees, a majority of part-time employees or none at all, as employers contributing funds to their own plans must also contribute for any eligible employees.
The biggest advantage is that qualified sole proprietors can make substantial tax-deductible retirement contributions much higher than the annual pretax contributions allowed with other retirement plan vehicles. As of 2015, the maximum annual benefit payable through defined benefit pension plans is $210,000. However, it is possible that annual contributions may be even higher, depending on the individual’s actuarial formula. In contrast, the maximum annual contribution to a 401(k) plan is $18,000.
In addition, making contributions to this type of plan doesn’t preclude also contributing to 401(k), SEP IRA or other retirement plans. If you are an employee at one place of business and the owner of a consulting service on the side, you can benefit both from the employer’s plan and a self-funded benefit pension plan.
Who should participate?
The best candidates are those with a high level of income through self-employment, who have part-time employees or who employ four or fewer full-time employees and who want to shelter as much of their present-day income from taxation as possible. It is not a good solution for those with inconsistent annual incomes. The calculation for defined benefit contributions is based on the average of the individual’s three highest years of income, but if that average doesn’t adequately reflect the possible valleys, you may have difficulty some years making the required contributions.
A defined benefit pension plan may not be a viable strategy if you plan to grow your business. Because you must make contributions for all eligible employees, if that number should increase, so will your required annual contribution. The plans also carry mandatory annual funding requirements and are more expensive to maintain than other types of retirement plans due to greater administrative fees. Discuss with your adviser whether your future earnings will continue to support annual contributions.
Also keep in mind that your contribution amount will be adjusted annually based on the actual performance of investment instruments selected. There’s no guarantee that funds won’t underperform over time to the point that the annual contribution becomes financially burdensome.
However, if you have a high, dependable annual income that you expect to maintain until retirement, a defined benefit pension plan can be an ideal way to maximize tax savings while securing a comfortable future.
Russell Faye is the Partner in Charge of Wiss' Healthcare Services Group. Additionally, he specializes in helping privately-held businesses meet their strategic and financial goals and manage the challenges of growth, cash flow, and organizational restructuring. Reach him at email@example.com or (973) 994-9400.